Divestment from fossil fuels, advocated by climate action campaigners such as Bill McKibben, is a blunt instrument for reducing carbon emissions, according to climate risk analyst Robert Litterman in an interview for The Conversation. Responding to climate risk, he argues, will depend on global action to reduce emissions.

Litterman worked for 23 years at Goldman Sachs, and retired in 2009 from head of risk analysis. He is now Chairman of the Risk Committee at global asset managers Kepos Capital LP. He is also a Director at the Asset Owners Disclosure Project. Recently in Australia, he was interviewed by climate economics expert Hugh Saddler at the Australian National University. Saddler also sits on the board at The Climate Institute.

Hugh Saddler: What sort of risks does climate change pose to investments?

Robert Litterman: Climate change exposes investments to many types of risks, including both anticipated and unanticipated impacts, and over both short and long run time horizons.

In the short run the first type of risk is the direct physical impact of extreme weather on exposed infrastructure. A second type of short run risk is the decline in demand for assets that create emissions because incentives are created to reduce the production of greenhouse gas emissions.

In the longer run, there are both the direct impacts of weather-related outcomes as well as the indirect effects of climate change such as rising temperatures, severity of storms, floods, droughts, forest fires, rising sea levels, acidification of the oceans, loss of ecosystem services, large increases in species extinctions, disease, human conflicts, food scarcity, etc.

In addition to the anticipated impacts of climate change, there is also the risk of exposure to a sequence of events that creates positive feedbacks leading to time compression and potentially catastrophic outcomes.

There may also be legal liability, similar to that levied against tobacco companies, for those corporations that have either created significant emissions and/or taken actions to prevent appropriate regulatory responses from being implemented.

Hugh Saddler: Which economic sectors/industries are most exposed to these risks?

Robert Litterman: Infrastructure investments and real estate are most exposed to extreme weather impacts, whereas high-carbon, expensive to extract, fossil fuel reserves are most exposed to the pricing of emissions.

Hugh Saddler: How large are these risks?

Robert Litterman: The size of the risk depends on the valuation of the exposed assets and extent of their exposure.

The magnitude of the exposure of infrastructure depends on its location and resilience to extreme weather.

The size of the exposure of fossil fuel reserves depends on the intensity of the emissions they create as well as the extraction expense. High-carbon fuels and those which are relatively more expensive to extract are the most exposed.

From a portfolio perspective, the magnitude of the total exposure depends on the concentration and size of the exposed assets.

Hugh Saddler: What is the overall implication of these risks for US investments as a whole? And for Australian investments, particularly superannuation funds?

Robert Litterman: The main implication of climate risks is that there is an urgent need to create appropriate global incentives to reduce greenhouse gas emissions. The atmosphere’s ability to safely absorb emissions is a scarce resource that is currently being wasted. Given the virtually unbounded magnitude of worst case climate change outcomes prudent risk management requires that the potential damages created by emissions be reflected in economic activities that create additional greenhouse gases. These implications are true for all investors, including those in the US and Australia.

Hugh Saddler: Is divesting from fossil fuels an economically sound strategy for an individual or, most particularly, a super fund, rather than just a moral argument?

Robert Litterman: Divestment of all fossil fuels is a rather blunt, expensive, and potentially risky response to the dangers created by climate change. It rests on a false premise that all fossil fuel companies are somehow unethical or immoral.

Fossil fuel companies are, for the most part, profit maximising entities that are optimising the valuation of shareholder’s investments given the irrational incentives that governments have created for them.

Certain fossil fuels, such as coal, which are often referred to as “stranded assets,” are clearly exposed to the potential loss of value created by the increased expectations of the introduction of incentives to reduce emissions. This asset valuation risk can, and should, be hedged.

Other fossil fuels, in particular natural gas, which is much cleaner than coal, may actually become more valuable, at least for some period of time, if those appropriate incentives to reduce emissions are put in place. Rather than divesting all fossil fuels, an economically sound response for investors is to hedge the stranded assets in a fund.

Hugh Saddler: What are the impediments to more comprehensive disclosure to individual investors of the nature and size of the risks? Are the regulation settings right?

Robert Litterman: Disclosure of climate risks embedded in portfolios is made extremely difficult by the complexity of the risks involved and the uncertainty of the global policy response. There have been few, if any, clear guidelines for disclosure, although clearly many funds are moving in the direction of creating additional transparency for their beneficiaries of the extent of their exposures.

Hugh Saddler: The coal industry argues that coal will be a sound investment for decades thanks to consumption in China and India. Divestment advocates say coal mines will become “stranded assets”. How are we to make sense of these contrasting arguments? What is the evidence that investing in coal is unsound?

Robert Litterman: The concept of a “carbon budget” refers to the unknown quantity of emissions which can be safely allowed into the atmosphere. The well-understood fact that higher levels of greenhouse gases in the atmosphere lead to higher risks of extreme, and potentially catastrophic climatic outcomes implies that a rational, risk-averse society should immediately create incentives to sharply reduce emissions.

To the extent that expectations of the creation of such incentives become more likely and at higher levels than currently exist, demand for coal, and thus it’s expected value, will decline.

Future consumption of coal in China and India, as well as the rest of the world, is highly uncertain and dependent on the expected future price of emissions. Arguments that rely on extrapolating past, unsustainable policies indefinitely into the future are fatally flawed.

The best evidence to date that investing in coal is unsound is the recently announced policy of the Stanford University endowment that it is divesting of its coal assets. This decision is likely to be the first of many such actions by investors around the globe. Clearly, investors who anticipate such a response will want to act before valuations are impacted.